Japanese companies have spread their operations outside their own
country more than any other nation. In particular, foreign direct
investment by Japanese companies has expanded and its traditional
destination has shifted to Europe and North America. This article
examines Japanese investment in the European Community, a market more
fragmented and protectionist than the U.S. The article discusses the
nature Of restrictions on Japanese exports to the EC, and then the
motives and choice of location for investment within the EC.

IF CORPORATE STRATEGY in the 1980s could be summarized in one word,
that word would be "globalization." More than any one else,
Japanese companies seem determined to spread their operations outside
the boundaries of their country. What makes the case of Japanese direct
investment interesting is not only its recent vintage and rapid growth
but also the change in its traditional destination.

The rapid increase in Japanese foreign direct investment (FDI) has
become a source of friction between Japan and other countries. In the
U.S. and the European Community (EC) it is widely believed among policy
makers and business leaders that Japanese firms are investing in order
to "Jump over tariffs" and to exploit opportunities from
"Europe 1992."

While these are not insignificant motives for the presence of
Japanese firms in North America and Europe, they belie the fact that
Japanese firms are able to survive competition in foreign markets
because they are at the leading edge of new technologies. They would
invest even in the absence of any barriers of trade, because
technological leadership requires them to behave like global companies.
It also implies that their rivals must compete with them in all their
major markets.(1)

We are witnessing the transformation of Japanese companies from
successful exporters into global companies with production facilities in
many countries. One way of demonstrating this transformation is to
examine investment by Japanese companies in the EC, which has a more
protectionist and fragmented market than the U.S. Investment decisions
are inevitably affected by the state of trade relations between home and
host countries. For multinational companies, exports and investment in
production facilities abroad are often alternative strategies for
reaching their markets. Their choice between the two depends on how easy
or difficult the alternative is. Therefore, in order to understand
investment decisions, it is important to put them in the context of the
EC-Japan bilateral trade relations.

RESTRICTIONS ON JAPANESE EXPORTS TO THE EC

The EC's trade dependence on Japan is minor. In 1988 Japan
accounted for only 4.2 percent of the EC's total imports. In the
same year Japan was the destination of a meager 1.6 percent of the
EC's total exports. By contrast, the EC received 16 percent of
Japan's exports and contributed to 12 percent of Japan's
imports. The EC's bilateral trade deficit with Japan amounted to
ECU21 billion in 1987.

Although these trade statistics would suggest that the EC would not
be overly concerned about its commercial relations with Japan, the
opposite is true. The EC's concern arises not only out of
Japan's export success but also out of the fact that Japan has so
far concentrated its exports in a few sectors. The maJority (53 percent
in 1989) of Japanese exports to the EC is accounted by only two broad
industrial sectors: electronics and transport equipment.

A recent study measuring Japan's comparative advantage found
that overall Japan showed stronger export competitiveness relative to
the EC in five sectors (ranked in order of importance): electronics,
precision equipment, road vehicles, machinery, and musical
instruments.(2) Given that protectionist pressure rises when competition
from imports increases, it is not surprising that most of the trade
friction between the EC and Japan is exactly in those industrial
sectors.

Japanese authorities and businessmen believe that the EC Commission
has targeted Japanese products for special punitive treatment.(3)
Although there may be a grain of truth in this belief, the EC is not
protectionist only with respect to Japanese products. If Japan suffers
more than other countries, it probably is because Japan is more
competitive than other countries. Nor are all the impediments to
Japanese exports masterminded by the Commission. For example, the reason
for friction in the trade of cars is because exports are restricted by
national barriers that are supposed to be swept away by the creation of
a single European market.

The Community has several instruments at its disposal for
implementing its commercial policy. The most important of these are the
common external tariff, customs valuation rules, country-origin rules,
import surveillance, antidumping and countervailing rules and the new
commercial instrument for dealing with illicit foreign practices (e.g.,
violations of copyrights and patents). However, imports can be
restricted by other means as well. Voluntary Export Restraints In 1987
the EC and its member states accounted for 138 out of a total of 261
known voluntary export restraints (VERs), mostly affecting textiles,
steel, agricultural products, footwear, cars and electronic products.(4)
Of those 138 VERs, 87 were EC-wide and 51 were arranged by national
governments. The majority of EC VERs (68 or 80 percent) covered steel,
agricultural products and textiles. Hence, the trade of industrial
products is controlled primarily by national VERs. Japan's two most
important export sectors, electronics and transport equipment, are both
restricted by VERs. It is believed that in 1988 the EC had at least
sixteen VERs (of which eleven were at national level) covering different
electronics products.(5) Car imports are currently restricted in four EC
countries: the U. K. (11 percent of the local market), France (3 percent
of the local market), Italy (3000 new cars per year, corresponding to
about 1 percent of the local market) and Spain (1-2 percent of the local
market). Recent press reports have also suggested that an informal
understanding exists between German car manufacturers and their Japanese
counterparts to limit the latter's exports to Germany to 15 percent
of the market.(6) The overall EC share is about 9-11 percent.

In addition to their own bilaterally negotiated VERs, some member
states also impose border restrictions on products from particular third
countries (the so-called Article 115 derogations," because they
need permission from the Commission in order to depart from their
obligation of maintaining free trade with the rest of the Community). At
the end of 1988 there were 96 EC-wide quantitative restrictions on
imports of manufactured products and 90 national restrictions.(7) Many
of them overlapped. Japan was affected by 6 EC and 53 national quotas.
Other target countries were South Korea (5/13), state-trading countries
(25/4) and developing countries (8/30). The most frequent users of Art.
115 derogations are France, Italy, Spain and Ireland.(8)

Antidumping

Japanese exports have been particularly affected by the EC's
antidumping policy.(9) In the nine years between 1980 and 1988, the EC
initiated about 350 antidumping investigations. The majority of those
investigations have been against products from East European (34 percent
of all cases) and East Asian (17 percent of all cases) countries. Much
attention and criticism has recently been attracted by the EC's
anticircumvention regulation.

In order to prevent circumvention of its antidumping duties, the EC
introduced the so-called screwdriver provision ("parts
amendment"). This additional regulation enables the EC to impose
duties on foreign products assembled within the Community provided that:

1. Assembly began or increased substantially after an antidumping
inquiry, and

2. The value-added by components from the home country of the
exporter exceeds 60 percent.

Therefore, in strict legal terms and contrary to a widespread
belief, the screwdriver regulation is not a local-content requirement
for inward investment, because it applies only to few products and
because it allows firms to use components of non-EC origin for the
remaining 40 percent of the value-added. Of course, a firm that has been
affected by antidumping measures may think that it will still remain
vulnerable to future antidumping complaints if its products do not
acquire enough European value-added in order to be classified as
European. The safest, although not necessarily the cheapest, course of
action is to manufacture within the EC or purchase components from EC
suppliers.

Japanese firms understandably believe that the screwdriver
regulation is aimed at them. All cases so far have involved Japanese
products electronic scales, electronic typewriters, photocopiers, VCRs,
dot matrix printers, ball bearings and excavators). Japan subsequently
contested the screwdriver regulation in GATT. In a decision issued in
March 1990, a panel of experts found in favor of Japan.

Rules of Origin

Rules of origin are needed because trade barriers are not uniform.
Some countries are given preference over other countries. Therefore,
rules that confer origin enable discriminatory policies to function
effectively. How the national origin of a product is determined is an
issue that does influence trade and direct investment, regardless of the
intentions of technocrats.

The EC's rules of origin were first implemented in 1968 when a
free trade agreement with EFTA countries came into force.(10) The
objective of the rules was to prevent trade deflection, i.e., the
importation of products from third countries via an EFTA country that
happened to have a lower tariff than the common external tariff of the
EC. For that purpose, it was necessary to determine the national origin
of traded products. The EC follows the general principle laid down in
the 1973 Kyoto Convention, which specifies that a product originates in
the country where the "last substantial process or operation"
takes place.

Until recently there was little international concern about rules
of origin. Most discussion took place at a technical level. Concern
heightened after the EC added a few qualifications to what the last
substantial process meant for photocopiers and semiconductors. It is
worth noting that the EC was probably within the limits of its
international legal obligations in determining how that general
principle was to be interpreted with respect to those two products. The
EC has also specified particular rules of origin for twelve other
products. The rules for photocopiers and semiconductors are the only
ones that were introduced in the 1980s. All the others were introduced
in the 1960s and 1970s.

Following an antidumping complaint in 1987 concerning photocopiers
from Japan, the EC decided that origin is conferred by- the country in
which the heat-resistant drums are manufactured. This decision had a
serious effect on Ricoh, which had begun exporting photocopiers to the
EC from a plant in California. The new rules effectively denied that
these photocopiers were of American origin. Similarly for
semiconductors, an antidumping complaint in 1985 led to the rule (in
1989) that origin is determined by the country in which circuit
diffusion is done. This rule has accidentally or intentionally favored
European producers that carry out the diffusion in Europe and final
assembly in other, low wage, countries.

The foregoing review of trade friction between the EC and Japan
leads to the following two conclusions:

1. Japan faces trade barriers in the industries in which it is most
competitive. At least until 1993, many of those trade barriers will be
determined at the national rather than Community level. If investment
decisions have been influenced by trade barriers, they are likely to
have taken into account these national restrictions.

2. Investment in production facilities within the EC does not
necessarily avoid restrictions on Japanese products. Rules of origin and
local-content requirements affect the inputs and, therefore, cost
competitiveness of certain products.

Given these conclusions three questions arise:

1. Have Japanese firms invested primarily in order to avoid trade
barriers?

2. if tariff-Jumping has been their major motive, have they
invested in the most protectionist markets?

3. Because local-content requirements make production in Europe
more costly than in other countries (i.e., Southeast Asia), have
Japanese firms located their manufacturing operations in the low-wage
areas or areas that offer the highest regional subsidies?

The answers to all three questions are negative. Available evidence
analyzed in the following section indicates that minimizing labor costs
does not appear to have been the major objective of Japanese
subsidiaries. Such observed behavior is consistent with the
globalization hypothesis. Producing in low-wage regions is of relative
little importance to global companies with high-tech products. What is
more important to them is close contact with the changing technical
requirements of their clients and the changing tastes of consumers.

JAPANESE DIRECT INVESTMENT IN THE EC(11)

Since 1985 Japan's total outward direct investment has
increased by more than 500 percent. In the 1985 fiscal year $12 billion
was invested abroad. By 1989 overseas investment reached $67 billion
annually, half of it going to the U.S. while the EC received more than a
fifth of it ($14 billion).

At the end of 1989 the book value of the stock of Japanese
investment in the EC was $42 billion. Table 1 shows the allocation of
that investment among EC member states. The U.K. has received almost 40
percent of investment in the EC and 35 percent of investment in the
whole of Europe. The four largest member states account for 73 percent
of investment. A reason for this concentration is that most of Japanese
FDI has been in services and especially financial services. Naturally,
London and Luxembourg have attracted a relatively large proportion of
that investment.

Table 2 shows the industrial distribution of Japanese investment.
Services account for 76 percent of total investment and financial
services alone represent 49 percent of that total. The most important
manufacturing activity, which is only a quarter of manufacturing
investment, is the production of electric and electronic goods (4.3
percent of total investment)

Several popular explanations have been offered for the spectacular
growth in Japan's outward direct investment. The major causes are
believed to be the 1985 appreciation of' the yen, the low cost of
borrowing in Japan and the need to avoid trade barriers.

Although these explanations may have some merit, they are seriously
incomplete. A currency appreciation by itself cannot stimulate
investment. Foreign assets may look cheaper but the return to investment
will be correspondingly lower when expressed in home currency. An
appreciation may stimulate investment only when a subsequent
depreciation is expected, so that the returns, expressed in home
currency, are higher than before. If exchange rate fluctuations could
account significantly for direct investment, a reversal in capital
outflows from Japan should have occurred already.

The low cost of borrowing is also an unsatisfactory explanation. In
a world of integrated financial markets, non-Japanese companies should
also have been able to benefit from the cheapness of Japanese capital.
What is even more puzzling is that Japanese subsidiaries abroad do not
always borrow from Japan when they expand their operations. There is
also investment from other countries into Japan. If FDI would flow only
from the low interest rate countries to high rate countries, no FDI
would take place in Japan.

There is an element of truth in the view that some Japanese
investment has been undertaken in order to avoid trade barriers. But
like the two previous popular accounts of Japanese corporate exodus, it
is an inadequate explanation. The majority of investment, which is in
services, has not been prompted by any significant increase in
protectionism. If anything, capital flowed to the countries that
liberalized their markets (e.g., U.K. and Luxembourg). Moreover,
Japanese companies have not invested greater amounts in the more
protectionist markets. According to recent studies, the EC is more
protectionist than the U.S. and, within the EC, France, Italy and
Germany are more protectionist than the U.K.(12)

The concentration of FDI in the U.K. may be explained on the
grounds that countries such as France and Italy also have barriers
against investment. But, this implies that the tariff-jumping"
hypothesis ignores the possible existence of other protectionist
policies. On the other hand, it may be argued that in an (almost)
integrated market, nationally determined external barriers are
irrelevant and Japanese firms would locate their operations in the
countries with the cheapest labor or highest incentives to investment.

Undoubtedly, some Japanese firms have invested in order to produce
behind the tariff walls of the EC. There are, of course, other good
reasons why Japanese firms invest in markets they are more familiar with
through their exports. They reduce the risk of failure by undertaking
investments in markets whose laws, regulations and customs are
relatively better known to them. Furthermore, their larger share of the
local markets achieved through exports is likely to provide them with
more information about local consumer tastes. But above all they would
not have been able to withstand local competition had they not been
global players with state-of-the-art technology.

A more general and credible explanation of the increase in
Japan's outward investment is that Japanese companies that aspire
to a global status, like American companies forty years earlier, need to
have a presence in their major markets. Thus they forge strong links
with their customers and local business communities. These links help
them to establish and defend their corporate image and brands. Not
surprisingly, the majority of Japanese manufacturing investment has
occurred in those sectors in which Japan has been a successful exporter:
machine tools and equipment, electronics and cars.

Investment in services can be explained by their own low
tradeability. Initially, a sizeable proportion of Japanese investment
was undertaken by trading companies. Their purpose was to channel
exports into new markets and send back to Japan foreign products. Still
today more than half of Japanese exports and imports are carried out by
trading houses.

In the financial sector, initial investment was undertaken in order
to serve Japanese companies abroad, engage in foreign exchange business
and participate in Eurocurrency markets. It is not surprising that
Luxembourg and the U.K. have attracted large amounts and a
disproportionate share of financial services, given that their financial
markets are well developed. As Japanese banks and securities houses
gained experience and knowledge of the European markets, they began to
provide more diversified services and even offer European financial
instruments (e.g., corporate bonds) to their Japan-based clients. Their
growing familiarization with and involvement in European markets is
manifest in the fact that in the past few years they have been active in
establishing new offices in other regions of the EC. This movement out
of the main financial centers is also the result of their strategic
repositioning in advance of the creation of a single market within the
EC.

Choice of Location

It may be thought that, once a Japanese firm is inside the tariff
walls of the EC, the choice of location for investment is insignificant.
Yet, some EC countries attract more overall investment and also more
investment in particular industries. Moreover, with the exception of
Spain, investment has not flowed to southern countries with cheap labor.

Table 3 shows the share of each industry relative to total
investment in each country and relative to total investment in that
industry in the whole of Europe (including non-EC countries; the EC
accounts for 93 percent of all Japanese investment in Europe). That most
of investment goes to the U.K., Germany and the Netherlands is easy to
understand. These are the traditionally liberal members of the EC. Yet,
the proportion of investment that goes to these countries varies quite
substantially across industries. This difference implies that, when
Japanese firms invest, the;, do not only consider the openness or
receptiveness of potential host countries but also whether they are
suitable locations for the particular needs of each industry.

When a firm considers investing abroad, its choice of location is
determined by the general attitude and policies of host countries
towards foreign investors and by specific factors that influence
individual industries (e.g., competitors' strategies, location of
maJor suppliers, location of major customers, etc.). Different
industries would have a natural tendency to agglomerate in different
countries if all governments followed neutral or similar policies on
foreign investment. Because policies are not neutral, investment
decisions are distorted by political or cultural factors.

In order to disentangle the industry-specific from the more general
political influences, Table 4 presents an index of Revealed Locational
Attraction (RLA). The index shows how attractive EC countries are to
different industries after the more general influences are removed. The
derived index removes the more general influences by normalizing each
country's share of investment in each industry. A neutral location
corresponds to an RLA value of one. Values of less than one show
locations that are not attractive, while values greater than one reveal
attractive locations. The greater the RLA number, the stronger the
perceived advantage of a location.

The results for the U. K. are somewhat surprising. In spite of its
large shares in almost all manufacturing sectors, it is not revealed to
have any particular advantage in these sectors. The only sector in which
the U. K. seems to do relatively better than other EC countries is in
real estate. These results, however, are likely to be biased by the fact
that the U.K. is the major recipient of Japanese FDI and that most of it
is in services.

Finally, Table 5 shows another index of locational attraction based
on the availability of incentives for investment. In an otherwise
integrated market, firms would establish their operations in the country
that offers the largest subsidy. The subsidies that would normally be
available to Japanese firms are those for regional development purposes
(apart from illegal subventions). The attractive countries for
investment would be those in which regional aid per capita is higher
than in other countries. The index allows us not only to rank countries
but also to determine how much more or less attractive each country is
relative to others. For example, the amount of regional aid available in
France is 45 percent more than that in Germany. But, considering that
France has a smaller economy, available aid makes it twice as attractive
as a location for investment.

In summary, the two indices show that, once general political
influences are removed, Japanese investment in different industries
tends to agglomerate at different locations and its destination is not
systematically affected either by low wages or subsidies. In consistence with the globalization hypothesis, Japanese firms tend to invest in
their main markets, which are also the markets that have been relatively
more open to their exports.

CONCLUSION

As demonstrated elsewhere, Japanese investment fits the pattern of
investment by American multinationals that came to Europe in the 1950s
and 1960s.(13) The latter expanded outside the U.S. at the time of
America's technological leadership. If indeed the American Example
can be a basis for predicting the growth of Japanese investment in
Europe, over the next decade it should more than triple. Perhaps the
major consequence of "1992" for American firms will not be
more European protectionism, but tougher competition by Japanese firms
located in Europe.

FOOTNOTES

1 Both of these implications have been extensively analyzed in
Michael Porter's Competitive Advantage, (Cambridge, MA: Harvard
University Press, 1981).

2 See B. Heitger and J. Stehn, Japanese Direct Investment in the
EC, Journal of Common Market Studies, 1990, vol. 29 (1), 1-15.

9 A more extensive analysis and further references can be found in
P. Nicolaides, EC Antidumping Policy, Tokyo Club Papers, 1990.

10 For a more detailed review of the EC rules of origin see Brian
Hindley, Foreign Direct Investment: The Effect of Rules of Origin, Roval
Institute of International Affaris, Oct. 1990.

11 The nature and effects of Japanese investment in the EC are
analyzed in depth in Stephen Thomsen and Phedon Nicolaides, The
Evolution of Japanese Investment in Europe, Harvester-Wheatsheaf,
forthcoming 1991). The data in this section are drawn from that book.

12 For references see Herrmann (1990), op. cit.

13 Thomsen and Nicolaides (1991), op. cit., examine at length the
similarities between American and Japanese FDI in Europe.